These Stocks Are in the Sweet Spot Right Now

by James Brumley | July 11, 2012 9:25 am

What do the stock market and TV’s The Brady Bunch have in common?

More than you might think.

One of the repeated stories of the beloved show from the early ’70s involved Jan and Peter Brady’s unique predicament. Some of you will know right away what that predicament was. For those of you who are not Brady Bunch aficionados, however, Jan was the second of three sisters, and Peter was the middle of three brothers. Both experienced “middle child” syndrome, meaning they were in the shadow of their more mature and socially savvy older siblings, yet weren’t as cute as the youngest son and daughter in the family.

From the middle children’s perspective, it’s a can’t-win situation, yet from the outside looking in, the two middle children are just as worthy as any of the other four.

Similarly, investors love the stability and visibility of large-cap stocks, the virtual older siblings of the equity market. Conversely, though clearly riskier, traders are willing to take swings on small caps, since they could have explosive growth potential.

And mid caps — the market’s proverbial middle children? As was the case with the Brady kids, mid-cap stocks are easy to overlook just because they don’t offer big-name stability, yet also don’t offer the growth opportunity associated with young, budding companies.

But overlooking those mid caps is a big mistake — especially right now.

Buy the Numbers

Yes, one could argue that mid caps sacrifice the best of both worlds, not being large enough to be super-stable, but not being small enough to muster red-hot growth. Or, you could argue just the opposite — that mid caps still are small enough to pack some growth punch, but are big enough to be plenty stable. It’s all a matter of perspective.

More important right now, mid caps are priced at a more attractive risk/reward ratio than large caps and small caps.

While the S&P 400 Midcap Index is the market’s laggard for the year so far, that’s more of an asset than a liability. It has kept the group at a relatively cheap P/E ratio compared to the S&P 500 Large Cap Index, as well as the S&P 600 Small Cap Index.

Specifically, the S&P 400 Index is trading at 16 times its projected 2012 earnings. Meanwhile, the S&P 500 is trading at 13.2 times its 2012 earnings forecast, and the S&P 600 is priced at 18.1 times its 2012 income estimate.

Click to Enlarge But wait a second … isn’t the S&P 400 more expensive than the S&P 500 at those P/E levels?

Yes, but not when you factor in growth rates.

Mid caps, as a group, are on pace to grow income by 19% this year, and by 18.7% in 2013. The S&P 500, on the other hand, is projected to increase its income by 7.6% this year, and 13.9% next year.

In simpler terms, the cost/growth ratios (more commonly referred to as the PEG ratio) say mid caps are giving you the most bang for your risk buck right now.

Oh, the S&P 600 is expected to grow its earnings by 21.7% this year and 28% next year, but you’re paying a hefty premium for that growth. And, when adding in the instability inherent with small-cap stocks and small-cap earnings, that premium compared to earnings growth just doesn’t make sense. Mid caps still offer the optimal mix of risk, reward and reliability. The fact that they’ve trailed the rest of the market this year makes them even bigger bargains right now.

Ways to Play

On board with the mid-cap opportunity? Good. Here are some ways to tap into the arena.

SPDR S&P MidCap 400 ETF (NYSE:MDY[1]): Simple and straightforward, this is the most basic way to invest in the bigger mid-cap theme.

iShares Russell Midcap Value Index (NYSE:IWS[2]): Mid-cap value stocks are almost the worst performers for the year, only better than large-cap value stocks, which are only up 5.3% year-to-date. Mid-cap value names are only up 6% for the year. Ergo, they have huge rebound potential.

iShares Russell Midcap Growth Index (NYSE:IWP[3]): Just a tad above the performance of the mid-cap value index, mid-cap growth stocks are only up 8.6% for the year so far.

If you’re not comfortable picking value or growth, don’t sweat it … it’s not going to make an enormous difference. The important piece of this puzzle is making a point of adding some mid-cap exposure, since odds are most investors are underexposed right now.

If you want to drill down to the sector-level, here’s that valuation and growth breakdown:

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.